Chengdu Expressway (HKG:1785) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Chengdu Expressway Co., Ltd. (HKG:1785) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Chengdu Expressway

How Much Debt Does Chengdu Expressway Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Chengdu Expressway had debt of CN¥3.26b, up from CN¥3.04b in one year. On the flip side, it has CN¥1.77b in cash leading to net debt of about CN¥1.50b.

How Strong Is Chengdu Expressway's Balance Sheet?

The latest balance sheet data shows that Chengdu Expressway had liabilities of CN¥1.51b due within a year, and liabilities of CN¥3.39b falling due after that. Offsetting these obligations, it had cash of CN¥1.77b as well as receivables valued at CN¥70.5m due within 12 months. So its liabilities total CN¥3.06b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥3.04b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chengdu Expressway's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 4.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly, Chengdu Expressway's EBIT fell a jaw-dropping 34% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Chengdu Expressway's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Chengdu Expressway actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Chengdu Expressway's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We should also note that Infrastructure industry companies like Chengdu Expressway commonly do use debt without problems. Taking the abovementioned factors together we do think Chengdu Expressway's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Chengdu Expressway that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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